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The late Ronald Coase is widely recognized for two hugely influential papers that revolutionized the way that economists and lawyers think about the world. The first was his work on the reason that individuals come together to form firms. The second was his equally famous work on what he called “social cost.” The conventional wisdom about that paper is that Coase wanted us to focus on how externalities could be better handled by private parties negotiating between themselves rather than the authority of a central government imposing a solution. George Stigler in fact coined the phrase “Coase Theorem,” which described the basic tenets of Coase’s work on the matter—that regardless of the initial allocation of property rights, individual bargaining about externalities is more efficient than government regulation when there are no transaction costs.

In plain English this means that in a hypothetical dispute between two individuals regarding the exercise of their property rights, it is “better” (i.e., economically efficient) if they bargain for a solution—as long as the bargaining is not fouled up by poorly defined rights, political meddling, or an extremely costly bargaining process. However, all of this has led the economics profession to focus primarily on the concept of externalities, not on the bargaining.

In a PERC conference beginning today, co-sponsored by the Liberty Fund, Inc., we suggest a significant departure from this perspective. Focusing on the externality takes us away from the liberty and responsibility that individuals have to work out problems without government intervention. Property rights that are clearly defined would, both theoretically and practically, do a much better job of working out disputes between property holders than the specter of constant government intervention and regulation. Liberty is better served by the bargaining and negotiations that private actors should be obliged and motivated to try in the vast majority of disputes. If the field of economics could be persuaded that the key point is not the externality, but the fact that bargaining would prevent almost everything that economists call an externality, it would go a long way towards promoting a free and responsible society and research that focuses on the importance of markets and freedom.

In this conference we will review the history of externalities starting with A.C. Pigou. We will then examine some of the applications that widely influenced later thinking on the matter, most notably Paul Samuelson’s textbook. Next we will look at Coase, the “revision” of the history and meaning of Coase by Stigler. We will then examine some of the practical applications that focus on bargaining as compared to externalities to illustrate the widespread advantages of emphasizing bargaining as the main vehicle to deal with disputes as compared to focusing on the externalities and the role of the state.

There are several questions we will consider: What exactly did Coase say? It was, after all, George Stigler, not Coase, who coined the phrase “Coase Theorem,” and Coase himself was apparently uncomfortable with the use of the phrase for much of his life. How does the general conception of the Coase Theorem differ from Coase’s actual work? How critical is Coase to our current debates about liberty, limited governments, and free markets today? What are the policy implications of focusing on externalities? What are the policy implications of a property rights approach?

We welcome readers’ thoughts on these questions below. For more on the legacy of Ronald Coase, see PERC’s Q&A with Steven Medema on the Coase Theorem in environmental economics.

Ronald Coase, who won the Nobel Prize in Economics for his study of transaction costs and how they influence everything from the size of private companies to society’s rules of legal liability, died in September at the age of 102. The outpouring of remembrances by scholars and students is testament to Coase’s enormous contributions to the fields of law and economics.

But Coase’s insights transcended academia by explaining, usually with refreshing simplicity, the complex machinations of the real world—an exceptional case in which few economists find much pleasure.

As Matt Ridley notes, Coase reminded us that economics is the study of how people actually behave, not how they should behave. Nonetheless, Coase’s teachings did influence private actions and public policy. Rare is the economist whose work doesn’t part rest on the shoulders of the Coase giant.

His proposal for auctioning off rights to the electromagnetic spectrum beat out the resource-wasting approach of government licensing. His theory of the firm influenced organizational structures. And his inquiry into social costs reshaped how policy makers, judges, and property owners think about resource conflicts.

Yesterday’s Bozeman Daily Chronicle featured an example of Coase’s practical relevance. A farm owner near the Bozeman airport filed suit claiming a change in flight plans interfered with her enjoyment of the property, upset her cows, and caused her emotional distress.

In a pre-Coasean world, we might conclude that, because the social costs of the airport’s operations exceeded the private costs, the airport has created something that academic economists used to call an “externality” that must be corrected by government intervention such as a tax, regulation, or court decree.

But Coase showed us that this thinking is destined to crash. Whether the airspace should be used for planes, or kept open for farmers and their cows, depends on the relative values of the two conflicting uses. And he stressed that the ability of the two parties to negotiate a mutually beneficial agreement heavily depended on myriad factors that can often prevent the best solution.

He suggested that government intervention is only necessary when the costs of negotiating are so high that the two parties cannot agree to use the resource efficiently, and he persuaded us that courts are quite good at mimicking the outcomes that costless markets would create; the common law is a powerful social invention.

In this case, the farmer and the airport were able to reach an agreement. As part of a settlement agreement ending the litigation, the airport will buy the land outright from the farmer and the nuisance and resource conflict vanishes. The airport director explained said the purchase will protect the land from development “that is not compatible with the airport.”

This outcome puts the disputed resource, the airspace, in the hands of the party who valued it most. It also avoids a regulation that would cost the airport more than it paid directly to the farmer. And it leads to lower ticket prices than would be possible under an inefficient regulatory solution.

So, the next time you fly in or out of Bozeman, Montana, remember Ronald Coase and his wisdom about markets as problem solvers and thank him for the discount.

Founded 30 years ago in Bozeman, Montana, PERC—the Property and Environment Research Center—is the nation’s oldest and largest institute dedicated to improving environmental quality through property rights and markets.

The goal of PERC’s programs is to fully realize the vision of establishing “PERC University,” where scholars, students, policy makers, and others convene to expand the applications of free market environmentalism.

PERC's fellowships share a common goal of exposing new scholars, students, journalists, and policy makers to free market environmentalism, as well as enable scholars already familiar with FME to explore new applications.